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Spring 2013Securities Regulation

Linda Boss

Module III Notes (Definition of Security)

January 31 st

CHAPTER 3: THE DEFINITION OF A ‘SECURITY’

Rules and Statutes1. Securities Act

a. 2(a)(1) i. definition of a “security”

ii. the broad term that’s focused on and interpreted in this statute is ‘investment contract’iii. combination of numerated items and catch-all phrasesiv. we focus on investment contracts, notes bonds and debentures

b. 2(a)(3) i. the term “sale” or “sell” shall include every contract of sale or disposition of a security or

interest in a security, for value. ii. The term “offer to sell”, “offer for sale” or “offer” shall include every attempt or offer to

dispose of, or solicitation of an offer to buy, a security or interest in a security, for value. iii. “offer to buy” shall not include preliminary negotiations or agreements between an issuer

and any underwriter or among underwriters who are or are to be in privity of contract with an issuer

c. 3(a)(3) i. except as hereinafter expressly provided, the provisions of this title shall not apply to any

of the following classes of securities—1. any note, draft, bill of exchange, or banker’s acceptance which arises out of a

current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited;

2. Exchange Acta. 3(a)(10)

i. definition of ‘security’b. 3(a)(14)

i. definition of ‘sale’ and sell’ii. specifies what is meant in securities futures and security-based swaps

c. 27i. jurisdiction of offenses and suits

d. 29i. validity of contracts

1. (a) any condition, stipulation or provision binding any person to waive compliance with any provision of this title or of any rule or regulation thereunder, or of any rule of a self-regulatory organization, shall be void.

I. Do the Securities Laws Apply?a. It’s important to know if something is a ‘security’ and regulated under securities laws


i. If Rule 10b-5 applies, contractual limits on remedies will be ineffectiveii. Federal jurisdiction and nationwide service applies

iii. Monitoring and enforcement of the SEC appliesiv. SEC registration for sale of securities

b. 40 years after enactment, definition of security was very broadc. in 1972, court constricted definition of a securityd. Security is a tough concept to define

i. A single member LLC buying 100% of shares of a corporation, that is not a securityii. Some courts say a ‘stock’ is a ‘stock’ and a single person buying all the shares of a stock

is a security transactione. Why do we force companies to disclose to investors?

i. We want to allocate capital in efficient ways1. The people and society would lose

ii. We reduce agency costs1. You’re more wiling to deal w/ a company if we know an agent is subject to

controls, including disclosure, so that an investor can make good decisions when voting or withdrawing or buying more

iii. It’s also a way of dealing w/ lots of people that want control over a company1. Just disclose the same information to all of them2. Overcome the problem that collective investors can’t coordinate and force

management to do the things they want management to doiv. If you purchase an unregistered security, all you have to show is that it was a security and

unregistered, and you get your money back plus interest. II. “Investment Contract”

a. SEC v. H.J. Howey Co. (1946)i. Facts

1. Howey Company had an orange grove2. It kept half the groves for itself and sold the other half to the public to help

finance development3. The purchasers mainly live far away and have no control over the development or

management of the orange grove4. the purchasers were only entitled to a cut of the profits, and that was the sole

motive to enter into the contract5. the groves are not divided in any way to show individual ownership by different

personsii. Issue

1. Were these contracts ‘investment contracts’ and therefore subject to securities laws

iii. Procedure1. District Court said these weren’t investment contracts, just real estate and

agreement contracts from seller to buyer2. Appellate Court agreed, and said investment contract must be speculative or

promotional in character, and tangible interest sold has to have intrinsic value independent of the success of the enterprise as a whole

iv. Holding1. This is an investment contract because it is a ‘contract transaction or scheme’

where—a. A person invests his money; b. In a common enterprise;


c. Is led to expect profitsd. Which are derived solely from the efforts of the promoter or a third party

i. Later cases, some say primarily from the efforts or others2. Note that each element must be satisfied

v. Reasoning1. Investment contract isn’t defined in Securities Act, but under common law form is

disregarded for substance and emphasis placed on economic reality2. Court adopted common law definition above, now known as the Howey test3. Immaterial whether enterprise is speculative or not, or whether there’s a sale of

property with or without intrinsic valuevi. CLASS NOTES

1. SEC is trying to close down this entire operation, not just a normal enforcement action

2. Draws interpretation from state blue-sky laws3. The tests and definitions for ’33 act applies across the board for the ’34 act as well

a. There are some slight wrinkles [notes, e.g.] but for the most part, they’re the same thing

4. Note that it can also be a scheme; doesn’t have to necessarily be a contract or agreement

5. Horizontal commonality—pooling assets w/ lots of other people in the hopes of a pro rata return

6. Can you have an investment contract w/ one investor?a. Some courts say yes, if you’re using vertical commonality

7. Note that the service contract was an option—you could buy the land w/o the service contract

a. But it doesn’t matter what the investors accepted, it’s what they were actually offered

8. Here they say you look at form over substance, but we’ll see in later cases they’ll say we’re going to look at form...

b. “A Person Invests his Money”i. International Brotherhood of Teamsters v. Daniel (1979)

1. Factsa. Employee was in the union, which negotiated a noncontributory

compulsory pension plan, as long as the employee gave continuous service for 20 years

b. Employee retired, but had a 6 month break, so didn’t get pension planc. Employee sued under securities act, claiming pension plan to be an

‘investment contract’2. Issue

a. Is a noncontributory, compulsory pension plan a ‘security’ within meaning of securities act?

3. Procedurea. District court denied motion to dismiss, holding it to be an investment

contractb. 7th circuit affirmed

4. holdinga. supreme court reversed—not an investment contract and not covered

under securities act5. reasoning


a. the employee doesn’t invest anything—he makes no payment toward the pension plan

b. a person who invests chooses to give up a specific consideration in return for a separable financial interest with the characteristics of a security

c. contributing labor is not an investment, it’s a way to obtain a livelihoodd. payments by the employer were not ‘on behalf’ of an individual employee,

since there was no fixed relationship between contributions to the fund and an employee’s potential benefit

i. someone who works 20 years gets the same amount as someone who works 40

6. ERISA covers pension plans, not the securities act7. CLASS NOTES

a. Argument is that his pension plan was an investment contract; and it wasn’t fully disclosed what he was investing in

b. not an investment contract/securityc. saying your contributing your labor isn’t consideration; saying the

contribution from your wages isn’t consideration is bullshitd. what does make sense in this case is that ERISA was passed right after this

guy’s issue, and it’s ERISA’s deal, not securities lawse. so they screw this guy to set up precedent for ERISAf. if non-contributory, no money out of your own pocket, you’re forced to

invest in this plan, then that’s ERISAg. adds a new element to the Howey test—the security has to not be

subject to a comprehensive legislative scheme [like ERISA]ii. Notes

1. The presence of an alternative federal regulatory regime that fully protects investors strongly influences whether something is a security governed by securities regulation

a. However, lower courts care little about state regulation when applying the Howey test

2. Voluntary pensions that require employee contributions are securities, but securities act exempts them from securities requirements

3. Voluntary/non-contributory pensions and mandatory/contributory pensions are not securities according to SEC

c. “In a Common Enterprise”i. with whom must the investor have something ‘in common’?

ii. SEC v. SG Ltd. (1st Cir. 2001)1. Facts

a. SG ran a virtual ‘game’ online where players put real money up for ‘virtual shares’ of ‘virtual companies’ on a ‘virtual stock exchange’

b. SG represented that this was a ‘game without any risk’ for a privileged company stock and guaranteed a 10% return monthly

c. 800 ‘players’ bought stocks using real money, which SG kept when the system collapsed

2. issuea. were the ‘virtual shares’ traded on a ‘game’ investment contracts and

therefore subject to the securities act3. procedure

a. district court said this was a game and therefore not a securities contract


4. holdinga. it is irrelevant whether it’s titled as a ‘game’, this is an investment contract

when applying the howey test—no other test is relevant5. reasoning

a. investment contracts do lie within the commercial world, but it is irrelevant whether the arrangement is characterized as a business deal or a game if it is defined as an investment contract under the howey test

b. investment of moneyi. representation of 10% monthly profit likely shows participants

purchased in anticipation of investmentc. common enterprise

i. horizontal commonality1. pooling of assets from multiple investors so that all share in

the profits and risks of the enterpriseii. vertical commonality

1. investor’s fortunes are tied to the promoter’s success rather than to the fortunes of his or her fellow investors

2. Broad vertical commonalitya. Requires well-being of all investors dependent upon

promoter’s expertise3. Narrow vertical commonality

a. Requires investors’ fortunes be interwoven and dependent upon the efforts and success of those seeking the investment or of third parties

iii. Adopts horizontal commonality standard 1. Need pooling

a. SG represented clients were pooled into single account

2. Need sharing of profit/riska. Ponzi or pyramid schemes inherently involve

sharing profits/risk and pooling6. CLASS NOTES

a. You’d only play this game to make money; you make money by more people contributing—clear ponzi scheme

b. The SEC is concerned about this because they want people to remain confident in investing markets

c. Also SEC doesn’t have to show any fraud, just failure to disclose in a prospectus—so that’s easier than just convicting them of fraud or mail fraud

d. They paid cash, it was horizontal common enterprise, the game was not a game it was led to expect profits, and the efforts were from primarily promoters

d. “Is Led to Expect Profits”i. “led” suggests that the actions of the promoter induce the investor to part w/ his or her

moneyii. United Housing Foundation, Inc. v. Forman (1975)

1. Factsa. Non-profit co-op was created for low income familiesb. Shares of stock were sold to residents entitling them to lease an apartment


c. When price of a unit went up, after shares were sold, residents sued co-op alleging they made false material misrepresentations under federal securities laws

2. Procedurea. Co-op says hey; not a security. Go away. b. District court grants dismissal for co-opc. Second circuit reverses

i. Labeled ‘stock’ = stock/securityii. Alternatively; it’s an Investment contract

d. Supreme court reverses3. Issue

a. Is a share sold to a resident, so that the resident can live in a non-profit co-op at a reduced rate, a ‘security’ under securities regulation laws?

4. Holdinga. No

5. Reasoninga. The sale of securities has the purpose of raising capital to make a profitb. Securities transactions are economic in characterc. These have 0 characteristics of stock; it matters 0 what its label is, so not a

stockd. Also not an investment contract because—

i. An investor is ‘attracted solely by prospects of a return’ on his investment

ii. When a purchase is motivated by a desire to use or consume the item purchased, securities laws don’t apply.

iii. The motivation behind these ‘stocks’ was to live at the apartment, not make a profit

iv. Representations by co-op repeatedly said the venture was nonprofit in nature

v. Getting a deduction in taxes or a cheaper place to live is not making a profit

vi. Howey test isn’t satisfied = not a security6. CLASS NOTES

a. Why even call this stock? So tenants can say they own their place; not just renting.

b. Makes it seem more like a neighborhood—not the projects. It’s a marketing tool.

c. Stock is not stock in circumstances where the investment clearly is not subject to SEC securities laws and has a completely different purpose than normal stock

d. They bought stock,the expectation was housing, not profitsiii. Syndication transaction

1. Promoter sells limited partnership interests to investors2. Limited partnership purchases some sort of complex3. Promoter manages real estate and pays a portion of rent to limited partners over

time4. Investment contract under securities laws

iv. SEC v. Edwards (2004)1. Facts


a. Payphone money scheme where people invested in payphones and the company paid them a guaranteed fixed return on their investment

b. When they went bankrupt, sued for material misrepresentations under securities laws

2. Procedurea. Appellate court said not an investment contract because—

i. Requires variable rate of return, not fixedii. Return on investment must be derived solely from efforts of others

—this wasn’t the case where there was a contractual guarantee of a fixed return

b. Supreme court reversed3. Issue

a. Whether scheme is not investment contract just because there’s a contractual entitlement to a fixed return

4. Holdinga. No

5. Reasoninga. ‘solely from efforts of others’ means other people make the money for the

investor; not that the amount of investment is dependent upon those effortsb. no distinction between fixed & variable returns on investment to

determine whether something is an investment contract6. CLASS NOTES

a. The investment is guaranteed. b. Investors trust the company because of the guaranteec. Another classic ponzi scheme—the only way to guarantee this fixed

investment is if more people invest. d. You have to expect ‘profit’

i. Is fixed guarantee a profitii. Howey says a ‘return on investment’ does that mean it has to be

variable? No. e. Guarantees ponzi schemes are under SECf. Purchased payphont, many purchasers, fixed return, and exclusively

promoters ran thingsv. Warfield v. Alaniz (9th Cir. 2009)

1. Factsa. Promoter sold annuities to people and made material misrepresentations

about the success of those annuitiesb. The annuities were charity annuities; the money would be distributed to

the annuitants but for the benefit of a charityc. This was actually a ponzi scheme; so people sued when the scheme went

under2. Procedure

a. District court found these were investment contracts under securities lawb. 9th circuit affirms

3. issuea. whether annuities for the benefit of a charity is an investment contract

4. holdinga. yep

5. reasoning


a. investors didn’t make an ‘investment of money’ because they lacked requisite intent to make a financial gain

i. this prong requires an investor to ‘commit his assets to the enterprise in such a manner as to subject himself to financial loss

ii. promoter promised to turn funds over that were made from annuities to charities—that’s an investment of money

iii. the focus is on what purchasers were offered or promised; not subjective intent of investors

iv. brochure emphasizes income generation and tax saving—that’s what investors were ‘led to expect’ and that’s the standard to determine whether they ‘invested money’

v. satisfies this prongb. investors had ‘no expectation of profits’

i. it was not impossible for purchaser to see a return on initial investment, depending on how long he or she lived

ii. the purchase may have anticipated an increase in investment value that would transfer over to a charity

iii. these are both expectations of profits, regardless of whether there was an expectation of net financial gain

iv. net financial gain does not = profitse. “Solely from the Efforts of the Promoter or a Third Party”

i. Partnerships/LLCs1. Solely has practically been written out of the requirement, because of issues with

LLCs/partnerships and franchises2. The general rule is that general partners getting an interest are not securities, but

limited partnership interests are a securitya. But if a limited partnership interest has control it becomes a non-securityb. Apply the Williamson test to determine if a general partnership interest is

a security3. if an LLC is member-managed it’s treated like a general partnership but if it’s

manager-managed it’s treated likely like a limited partnership, depending upon the limited partners’ rights and control over the LLc

ii. SEC v. Merchant Capital, LLC (11th Cir. 2007)1. Facts

a. Two men formed Merchant, a company that was going to purchase debt from banks and credit card companies

b. To raise money, they got members of the general public to become partners

c. The partners had no control except to vote for a general manager—which was Merchant

d. The money was pooled to purchase debt from New Vision pursuant to a contract between the two

2. Issuea. Was this an investment contract under securities laws?

3. Holdinga. Yes

4. Reasoning


a. An interest does not fall outside the definition of an investment contract just because the purchaser has some nominal involvement with the operation of the business

b. The focus is on the dependency of the investor on the entrepreneurial or managerial skills of a promoter or other party

c. Limited partnershipi. It’s not necessarily true that just because you’re a limited partner

you don’t have control of the profitability of your investmentii. Control can be altered by agreement

iii. No bright line rule adopted as suchd. General partnership

i. Not an investment contract, because of active involvement in management

ii. however, a general partnership can still be an investment contract if general partner in fact retains little ability to control the profitability of the investment (Williamson factors)

e. limited to assess expectations of control at the inception of the investment

f. Williamson factors—a general partnership or joint venture interest can be designated a security if the investor can establish that—

i. An agreement among the parties leave so little power in the hands of the partner or venture that the arrangement in fact distributes power as would a limited partnership;

1. Removal of manager was only for cause and investor has no other ability to impact management = investment contract

2. Unanimous votes of partners was requiredii. The partner or venture is so inexperienced and unknowledgeable in

business affairs that he is incapable of intelligently exercising his partnership or venture powers; or

1. Individual partners had no experience in debt purchasing business

iii. The partner or venture is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers

1. The investments were tied up in a contract between Merchant and New Vision—couldn’t get rid of the manager

iv. If any one of these factors is present—it’s a security5. Result of the case is that the same exact document can be a security in the hands

of one person and not a security in the hands of another. iii. SEC v. Mutual Benefits Corp. (11th Cir. 2005)

1. Factsa. MBC, viatical settlement provider, sold interests in life insurance policies

to investorsb. MBC did extensive investigation and analysis into life expectancies before

selling the interestsc. After interest was sold, MBC did nothing except wait to see how accurate

life expectancy was, then return on investment was realized or not


2. Issuea. Were the sale of these interests securities under federal securities laws?

3. Holdinga. Yes

4. Reasoninga. Just because there is little action or effort involved after the money was

invested does not mean the profits aren’t based ‘solely on the efforts of the promoter or third party’

b. No basis for excluding pre-purchase managerial activities from this analysis

iv. A D.C. circuit case Life Partners goes the other way because there’s no management after the sale of the investment

f. Real Estate Investment Contract Security Slidei. A is a security—classic timeshare

ii. B is a security if the real estate agent is selling a package deal—remember it’s what the person is selling and how they portray the investment to buyers

1. If Dubois gets profits, no-brainer security2. If Dubois is obligated to recommend, security3. If Dubois just mentions there’s an option of renting the apartment or condo, not a

security, but when she says if you rent here’s a package from a management company, it becomes a security.

a. A tie to the management company is not requirediii. C-not a security because there’s no horizontal commonality. Each person is buying a 1

week golf space and they can use it or rent it, both profits come to them personally. No pooling.

1. There are no collective action problems hereiv. D—not a security. If you apply the Howey test like a statute you might say yes, but if

you look at the big picture this is no different than hiring a lawn service to keep up your house or being in a neighborhood with an HOA.

1. No one’s giving up the money and telling someone to run the business for them2. You’re not counting on the dues to be your investment; your investment is the

land and the house. 3. No agency cost issues as part of the investment

g. Business Interest Hypothetical Slidei. A—stock is stock is stock. This is a security. If this changed to an LLC, things would be

very different and it might not be a security. But in this case, it’s definitely a security. Nothing changes b/c it’s closely held, b/c they’re sophisticated, etc.

1. Note that there will be an exception w/ regards to prospectus filing for small corporaitons like this

ii. B—presumptively they’re buying a security. Williamson suggests otherwise—they have powers under the agreement. They’re NOT likely able to exercise those powers because they have 0 sophistication. That means this is probably a security, also b/c they’re turning this over to Goodacre. Does it make sense that the answer is that this is a security?

1. The sophistication has to be specific—do they have this kind of knowledge dealing w/ this kind of business?

2. Since one Williamson factor is present—this is a security. iii. C—they did have power to control; they did exercise that power; the management

company wasn’t unique or special; so this is most likely not a security. The Williamson


test is not met. The partners are presumptively not security. Doesn’t matter if there’s a contract between the two—they still can have those contract protections but it doesn’t make it a security.

iv. D—not a security, because she had the ‘power’ to explore something and look into the operating agreement. She did no due diligence before becoming a member. She was sophisticated enough to look into the background of the LLC.

III. Stocka. whether a business interest is a security—holding says stock is stock—don’t care if it’s an entire

business interest. i. Selling all of the assets of a business is not a security, although it has the same effect as

selling 100% of the stock of a companyii. Corporations

1. Stocks are always securities, whether public held or closely heldiii. Limited partnership

1. Limited partner interest is generally a security, but general partner interest is generally non-security

iv. Limited liability company1. Manager managed is generally security2. Member managed is generally non-security

b. Landreth Timber Company v. Landreth (1985)i. Facts

1. A buyer purchased all of the stock of a company from sellers2. The investment went sour and buyer then sued seller, alleging misrepresentations

were made and not filed w/ SECii. Issue

1. Is the sale of ‘stock’ a security covered under the federal securities acts if the sale involves all of the stock, in order to acquire a business?

iii. Holding1. As long as it has the characteristics of stock, it’s a stock under the securities act

iv. Reasoning1. Stock characteristics

a. The right to receive dividends contingent upon an apportionment of profitsb. Negotiabilityc. The ability to be pledge or hypothecatedd. The conferring of voting rights in proportion to the number of shares

owned; ande. The capacity to appreciate in value

2. The instruments in this case have all of these characteristics, therefore are stocks. 3. The howey test applies to investment contracts, not ‘securities’ or stock4. The Securities Acts are not intended to cover only passive investors and not

privately negotiated transactions involving the transfer of control to entrepreneursIV. “Note”

a. What have securities courts done in this area?i. The statute creates an assumption that if something is called a ‘note’ it is a security

ii. We’re then told some notes are not securities—1. Those that arise out of a current transaction or the proceeds of which have been

used or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any


renewal thereof the maturity of which is likewise limited (Securities Act)—exemption under the Act

2. Then the statute also says the term security means any note…but doesn’t include currency or any note, draft, bill or exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited (Exchange Act)—exclusion under the Act

iii. What does that language mean?1. Securities Act (covers registration)

a. Short-term notesb. For when [usually larger] companies need short-term loans to cover some

expenses quickly [from banks, insurance companies, mutual funds] at decent interest rates

i. ‘commercial paper’2. Exchange Act (covers secondary transactions)

a. No ‘commercial paper’ like aboveb. Even without these protections, we can use mail/wire fraud to regulate

commercial paper fraudiv. Difference between commercial and consumer transactions

1. Consumera. An individual is the issuer of a noteb. Usually issued by the bank

2. Commerciala. Also usually issued by the bankb. Short-term note

3. Neither are securities4. That’s the basis of the ‘test’

b. Reeves v. Ernst & Young (1990)i. Facts

1. A co-op, in order to raise money, sold promissory notes payable on demand by the holder, to investors

2. Marketed the scheme as an ‘investment program’3. Company went bankrupt4. Investors sued accounting firm under securities act, saying that they failed to

follow generally accepted accounting principles5. Accounting firm said these notes don’t fall within securities regulation scheme6. They sue in federal court b/c they are using securities regulations laws against the

accountantii. Issue

1. Were the notes ‘securities’ under securities regulations?iii. Holding

1. Yes, but only b/c they passed the new test to determine whether a note is a ‘security’ note or not

iv. Reasoning1. There are lots of notes that don’t fall under securities regulations scheme

a. Congress didn’t intend to provide a broad federal remedy for all fraudb. Notes are used in a variety of settings, not all of which involve

investments2. Other Circuits’ approaches


a. “investment vs. commercial” approachb. “family resemblance” approach

i. presumption that any note more than 9 month term is a ‘security’ii. presumption can be rebutted by showing that this note ‘bears a

strong family resemblance’ to any of the notes on the “not a security list”

c. Howey test applied to notes3. Supreme Court adopts a modified “family resemblance” test

a. Can’t adopt a bright-line rule—but w/ this test basically all commercial transactions are not going to satisfy security requirements

b. Begin with a presumption that every note is a securityc. Rebut the presumption by showing that the note does not bear

characteristics of a ‘security’ d. Use the following characteristics to determine if the note is for

‘investment’ or ‘commercial’ purposesi. Assess the motivations that would prompt a reasonable seller and

buyer to enter into it—we’re asking what the purpose of the note was—investment or loan of some sort?

1. Seller’s purpose is to raise money for general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate = security

2. Note is exchanged to facilitate the purchase and sale of minor asset or consumer good, to correct for the seller’s cash-flow difficulties or to advance some other commercial or consumer purpose = no security

ii. Examine the ‘plan of distribution’ of the instrument to determine whether it is an instrument in which there is ‘common trading for speculation or investment’—was there a ‘collective action’ issue? Can people easily band together and take action?

iii. Examine the reasonable expectations of the investing public? 1. Court will consider instruments to be securities on the basis

of public expectations, even where economic analysis of the circumstances might suggest instrument is not security

2. It was called an ‘investment’iv. Examine whether some other factor, like existence of another

regulatory scheme, reduces risk of the instrument, rendering application of securities act unnecessary?—this is like the additional test that was added to Howey [ERISA]

e. Rebut the presumption by showing that the note in question does not bear/or does bear a strong resemblance to notes that have all of the above characteristics

4. The exception for ‘any note which has a maturity at the time of issuance of not exceeding nine months’ does not apply here, because ‘on demand’ does not = immediate maturity under the securities acts.

v. Dissent1. Notes payable on demand have an immediate maturity date, as defined at the time

the securities act was passed


2. This is a short-term instrument the way he reads the statute and therefore is excepted from the securities act

vi. If you put this test by Howey, they tend to look very similar. 1. Same collective action and agency costs analysis

c. Why do we have 2 acts with different definitions of ‘commercial paper’ how do you square these two?

i. Some things are securities; some things are notes; some are both. 1. Reeves case—co-op gave notes to farmers; those were securities2. Consumer/commercial notes are not securities

ii. Under the ’33 Act, some notes are subject to the Act and some are not. 1. Those that are ‘commercial paper’ are subject to the 33 Act, but not subject to

registration. a. It’s a security, just doesn’t need to register

iii. Under the ’34 Act, some notes are subject to Act and some are not1. Those that are ‘commercial paper’ are not subject to the ’34 Act at all.

iv. The Supreme Court doesn’t really understand this. d. Note Hypothetical Slide

i. A—not a security. Meets family resemblance test for a consumer note. ii. B—under ’33 act it’s subject to registration. Under the ’34 act it’s not a security at all.

Consumer notes aren’t subject to this distinction though—they’re excluded under both 33 and 34.

iii. C—almost by definition this is going to be hundreds of people b/c it’s a co-op. collective action issues. This is the Reves case.

iv. D—not a commercial transaction. Yes it is a security, under Reves test. V. Securitization

a. Securitization is the pooling of non-liquid assets and then selling the interests in the returns from that pool

b. Common assets used are—i. Home mortgages, student loans, credit card receivables

c. How it works—i. Originator creates pool and sells to SPV

ii. SPV sells interests in stream of money from pooliii. SPV uses proceeds to fund initial purchase of underlying pooled assets from the

originatord. Apply howey test to determine if a security

i. Issue is whether investor’s returns are solely through efforts or othersii. Usually they’re investment contracts, though

e. Asset-backed securitiesi. Securitization often results in the issuance of debt securities backed by the assets of the

securitization poolii. Asset-backed securities almost always meet the Reves test and are securities

iii. SEC promulgated Regulation AB which requires increased disclosure for asset-backed securities

iv. Prior to selling asset-backed securities, SPV may structure security to enhance credit worthiness

1. Provide additional cash collateral to SPV2. Third party guaranty3. Dividing SPV issued securities into different classes

f. Securitization makes assets more saleable and liquid


g. Credit default swapi. Allows two parties to exchange the risk of default of a chosen underlying instrument

ii. One party agrees to pay the principal in case a home mortgage defaults and the other agrees to pay a stream of payments in return for the promise to receive the principal amount in case of a default

iii. Serves essentially as an insurance functioniv. Speculators use these to profit from potential defaults

VI. Dodd Frank Act of 2010a. Principal goals is to discourage systemic risk posed by large financial institutions that serve as

sponsors of SPVs that issue asset-backed securitiesb. Requires SEC to implement rules to prohibit underwriters of asset-backed security as well as

placement agents, initial purchasers, etc. from engaging in any transaction that results in a material conflict of interest with any investor for a period of one year after the first closing date of the asset-backed security

c. Gives SEC regulatory authority for over-the-counter derivatives, imposing record keeping and recording requirements and central clearinghouse and exchange-traded

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